Lecture – 3: Financial Statements
Analysis
Project Financial Management
Learning Outcomes
• Financial Statements Analysis
• Need of FSA
• Standardizing Statements
• Financial Ratio Analysis
• Short-term solvency, or liquidity, ratios.
• Long-term solvency, or financial leverage, ratios.
• Asset management, or turnover, ratios.
• Profitability ratios.
• Bankruptcy and Financial Distress
Financial Statements Analysis
• Transforming data from financial statements into
information that is useful for informed decision making.
• Financial statement analysis is the process of reviewing
and evaluating a company's financial statements (such as
the balance sheet or profit and loss statement), thereby
gaining an understanding of the financial health of the
company and enabling more effective decision making.
Prerequisite
• A good working knowledge of financial statements is
desirable simply because such statements, and numbers
derived from those statements, are the primary means of
communicating financial information both within the firm
and outside the firm.
Need of FSA
• One of the role of a financial manager is to make
decisions
• The firm itself and outside providers of capital –creditors
and investors – all undertake financial statement analysis.
• The type of analysis varies according to the specific
interests of the party involved.
Need of FSA
• Trade creditors
– (suppliers owed money for goods and services) are
primarily interested in the liquidity of a firm.
– Their claims are short term, and the ability of the firm to
pay these claims quickly is best judged by an analysis of the
firm’s liquidity.
• Bondholders
– The claims of bondholders are long term. Accordingly,
bondholders are more interested in the cash-flow ability of
the firm to service debt over a long period of time. They
may evaluate this ability by analyzing the capital structure
of the firm, the major sources and uses of funds, the firm’s
profitability over time, and projections of future
profitability.
Need of FSA
• Shareholders
– Investors in a company’s common stock are principally
concerned with present and expected future earnings
As a result, investors usually focus on analyzing
profitability.
– They would also be concerned with the firm’s financial
condition as it affects the ability of the firm to pay
dividends and avoid bankruptcy.
Need of FSA
• Managers
– Internally, management also employs financial analysis
for the purpose of internal control and to better provide
what capital suppliers seek in financial condition and
performance from the firm.
– From an internal control standpoint, management
needs to undertake financial analysis in order to plan
and control effectively.
– To bargain effectively for outside funds, the financial
manager needs to be attuned to all aspects of financial
analysis that outside suppliers of capital use in
evaluating the firm.
STANDARDIZING STATEMENTS
• One obvious thing we might want to do with a company’s
financial statements is to compare them to those of other,
similar companies.
• It’s almost impossible to directly compare the financial
statements for two companies because of differences in size.
• For example, Ford and GM are obviously serious rivals in
the auto market, but GM is larger, so it is difficult to
compare them directly.
• The size problem is compounded if we try to compare GM
and, say, Toyota.
STANDARDIZING STATEMENTS
• To start making comparisons, one obvious thing we might
try to do is to somehow standardize the financial
statements. One common and useful way of doing this is
to work with percentages instead of total dollars. The
resulting financial statements are called common-size
statements.
Common-size statements.
• A common size financial statement displays all items as
percentages of a common base figure. This type
of financial statement allows for easy analysis between
companies or between time periods of a company. The
values on the common size statement are expressed as
percentages of a statement component, such as revenue.
COMMON-SIZE BALANCE SHEET
Common Size Income Statement
Financial Ratios Analysis
• A ratio analysis is a quantitative analysis of information
contained in a company’s financial statements.
• Ratio analysis is based on items in financial
statements like the balance sheet, income statement.
Financial Ratios Analysis
• What is it intended to measure, and why might we be
interested?
• What might a high or low value be telling us?
• How could this measure be improved?
Types of Ratios
• Short-term solvency, or liquidity, ratios.
• Long-term solvency, or financial leverage, ratios.
• Asset management, or turnover, ratios.
• Profitability ratios.
SHORT-TERM SOLVENCY OR LIQUIDITY MEASURES
• As the name suggests, short-term solvency ratios as a
group are intended to provide information about a firm’s
liquidity, and these ratios are sometimes called liquidity
measures.
• Liquidity ratios are particularly interesting to short-term
creditors. Because financial managers are constantly
working with banks and other short-term lenders, an
understanding of these ratios is essential.
SHORT-TERM SOLVENCY OR LIQUIDITY MEASURES
• Current Ratio One of the best-known and most widely
used ratios is the current ratio.
• Because current assets and liabilities are, in principle,
converted to cash over the following 12 months, the
current ratio is a measure of short-term liquidity.
• We could say Prufrock has $1.31 in current assets for
every $1 in current liabilities,
SHORT-TERM SOLVENCY OR LIQUIDITY MEASURES
• Quick Ratio Inventory is often the least liquid current
asset. It’s also the one for which the book values are least
reliable as measures of market value because the quality
of the inventory isn’t considered. Some of the inventory
may later turn out to be damaged, obsolete, or lost.
SHORT-TERM SOLVENCY OR LIQUIDITY MEASURES
• The quick ratio here tells a somewhat different story than
the current ratio because inventory accounts for more than
half of Prufrock’s current assets.
• To give an example of current versus quick ratios, based
on recent financial statements, Walmart and Manpower,
Inc., had current ratios of .89 and 1.12, respectively.
However, Manpower carries no inventory to speak of,
whereas Walmart’s current assets are virtually all
inventory. As a result, Walmart’s quick ratio was only .27,
and Manpower’s was 1.12, the same as its current ratio.
SHORT-TERM SOLVENCY OR LIQUIDITY MEASURES
• Cash Ratio A very short-term creditor might be
interested in the cash ratio:
• You can verify that this works out to be .18 times for
Prufrock.
LONG-TERM SOLVENCY MEASURES
• Long-term solvency ratios are intended to address the
firm’s long-run ability to meet its obligations or, more
generally, its financial leverage. These ratios are
sometimes called financial leverage ratios or just
leverage ratios . We consider three commonly used
measures and some variation
• Total Debt Ratio
– The total debt ratio takes into account all debts of all
maturities to all creditors. It can be defined in several
ways, the easiest of which is this
LONG-TERM SOLVENCY MEASURES
• In this case, an analyst might say that Prufrock uses 28
percent debt. Whether this is high or low or whether it
even makes any difference depends on whether capital
• structure matters,
LONG-TERM SOLVENCY MEASURES
• Times Interest Earned Another common measure of long-
term solvency is the times interest earned (TIE) ratio .
• As the name suggests, this ratio measures how well a
company has its interest obligations covered, and it is often
called the interest coverage ratio. For Prufrock, the interest
bill is covered 4.9 times over
LONG-TERM SOLVENCY MEASURES
• Cash Coverage
• A problem with the TIE ratio is that it is based on EBIT,
which is not really a measure of cash available to pay
interest. The reason is that depreciation and, noncash
expenses, have been deducted out. Because interest is
most definitely a cash outflow (to creditors), one way to
define the cash coverage ratio is:
LONG-TERM SOLVENCY MEASURES
• The numerator here, EBIT plus depreciation and
amortization, is often abbreviated EBITDA (earnings
before interest, taxes, depreciation, and amortization). It is
a basic measure of the firm’s ability to generate cash from
operations, and it is frequently used as a measure of cash
flow available to meet financial obligations.
ASSET MANAGEMENT OR TURNOVER MEASURES
• The efficiency with which Prufrock uses its assets.
• The measures in this section are sometimes called asset
management or utilization ratios .
• What they are intended to describe is how efficiently, or
intensively, a firm uses its assets to generate sales. We
first look at two important current assets: inventory and
receivables.
Basic assumption of scarce resources and their utilization
ASSET MANAGEMENT OR TURNOVER MEASURES
• Inventory Turnover and Days’ Sales in Inventory
During the year, Prufrock had a cost of goods sold of
$1,344. Inventory at the end of the year was $422. With
these numbers, inventory turnover can be calculated as:
• In a sense, we sold off, or turned over, the entire inventory
3.2 times during the year. As long as we are not running
out of stock and thereby forgoing sales, the higher this
ratio is, the more efficiently we are managing inventory.
ASSET MANAGEMENT OR TURNOVER MEASURES
• If we know that we turned our inventory over 3.2 times
during the year, we can immediately figure out how long
it took us to turn it over on average. The result is the
average days’ sales in inventory:
• This tells us that, roughly speaking, inventory sits 114
days on average before it is sold.
• About 114 days to work off our current inventory.
ASSET MANAGEMENT OR TURNOVER MEASURES
• Receivables Turnover and Days’ Sales in Receivables
Our inventory measures give some indication of how fast
we can sell products. We now look at how fast we collect
on those sales. The receivables turnover is defined in the
same way as inventory turnover:
• We collected our outstanding credit accounts 12.3 times
during the year
ASSET MANAGEMENT OR TURNOVER MEASURES
• This ratio makes more sense if we convert it to days, so
the days’ sales in receivables is:
• Therefore, on average, we collect on our credit sales in 30
days. For obvious reasons, this ratio is frequently called
the average collection period (ACP).
ASSET MANAGEMENT OR TURNOVER MEASURES
• Total Asset Turnover Moving away from specific
accounts like inventory or receivables, we can consider an
important “big picture” ratio, the total asset turnover
ratio. As the name suggests, total asset turnover is:
• In other words, for every dollar in assets, we generated
$.64 in sales
PROFITABILITY MEASURES
• Profit Margin Companies pay a great deal of attention to
their profit margins
• This tells us that Prufrock, generates a little less than 16
cents in net income for every dollar in sales.
PROFITABILITY MEASURES
• EBITDA Margin Another commonly used measure of
profitability is the EBITDA margin. As mentioned,
EBITDA is a measure of before-tax operating cash flow.
It adds back noncash expenses and does not include taxes
or interest expense. As a consequence, EBITDA margin
looks more directly at operating cash flows than
• Does not include the effect of capital structure or taxes.
For Prufrock, EBITDA margin is:
PROFITABILITY MEASURES
• Return on Assets Return on assets (ROA) is a measure of
profit per dollar of assets. It can be defined several ways,
4 but the most common is:
PROFITABILITY MEASURES
• Return on Equity Return on equity (ROE) is a measure
of how the stockholders fared during the year. Because
benefiting shareholders is our goal, ROE is, in an
accounting sense, the true bottom-line measure of
performance. ROE is usually measured as:
• Therefore, for every dollar in equity, Prufrock generated
14 cents in profit
Financial Distress/ Bankruptcy
• Costs of Financial Distress
• DIRECT COSTS OF FINANCIAL DISTRESS
• INDIRECT COSTS OF FINANCIAL DISTRESS
Financial Distress
• Firms deal with financial distress in several ways, such as
these:
– Selling major assets.
– Merging with another firm.
– Reducing capital spending and research and
development.
– Issuing new securities.
– Negotiating with banks and other creditors.
– Exchanging debt for equity.
– Filing for bankruptcy.
Bankruptcy Liquidation and Reorganization
• Firms that cannot make required payments to creditors
have two basic options:
• Liquidation
– Termination of the firm as a going concern. Selling the
assets of the firm for salvage value. The proceeds are
distributed to creditors in order of priority.
• Reorganization
– Is the option of keeping the firm a going concern; it
sometimes involves issuing new securities.
Bankruptcy
• A legal proceeding and can be done voluntarily with the
corporation filing the petition or involuntarily with the
creditors filing the petition.
Priority of Claims
• Administration expenses associated with liquidating the
bankrupt company’s assets.
• claims arising after the filing of an involuntary
bankruptcy petition.
• Wages, salaries, and commissions.
• Contributions to employee benefit plans arising within
180 days before the filing date.
Priority of Claims
• Consumer claims.
• Tax claims.
• Secured and unsecured creditors’ claims.
• Preferred stockholders’ claims.
• Common stockholders’ claims
Predicting Bankruptcy
• Many lenders use credit scoring model to asses the credit
worthiness of prospective borrower.
• The general idea is to find the factors that enables lenders
to discriminate between the good and bad credit borrower
• Z-Score model developed by Edward Altman in 1969.
• This model predict bankruptcy for publicly traded
manufacturing firms.
Z-Score
• The firm must traded in stock exchanges
• The firm must be involve in manufacturing Business
Z-Score Decision
• The firm would be considered bankrupt if
– Z-Score value is less than or equal to 1.81
• The firm would be considered healthy if
– Z-Score value is greater than or equal to 2.99
• The firm would be considered a gray area if
– Z-Score value is between 1.81 and 2.99
Z-Score Model for private firm
• For private and non manufacturer firms following Z-score
model is used.
Z-Score Decision for private firm
• The firm would be considered bankrupt if
– Z-Score value is less than or equal to 1.23
• The firm would be considered healthy if
– Z-Score value is greater than or equal to 2.90
• The firm would be considered a gray area if
– Z-Score value is between 1.23 and 2.90
